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Capital Spending: Not the Prettiest of Pictures

The emerging picture on capital spending is far from encouraging. To be sure, a number of temporary influences beset the quarter just past, a circumstance that will likely produce a bounce in the spring and possibly the summer quarter as well. But behind such quarter-to-quarter swings, fundamentals point to a still slow pace of such spending and by implication in the general recovery as well. Matters could be worse. The capital spending picture is not so bad that it will scotch the general recovery. At the same time, it argues strongly against any expectation of a general economic acceleration, much less a return to historic real growth rates any time soon.

Short-Term Swings

Recent statistics certainly make for grim reading. During the six months ended this past March, the most recent period for which data are available, sales and orders of new non-defense capital goods have fallen at an annual rate of about a 5.0 percent. Were it not for the volatile aircraft segment, orders would have fallen at a 11.3 percent annual pace. Broader measures, reported in the country’s national income and product accounts, show even steeper declines. According to these, sales after inflation barely increased during the first quarter this year, expanding at a mere 0.1 percent annually in real terms. Computer sales to business fell at a whopping 29.2 percent annual rate, while sales of industrial equipment fell at a 7.9 percent rate. New real commercial and industrial construction fell at a startling 23.1 percent annual pace, with the greatest drop, a 48.7 percent decline, was recorded for wells and mining. The only broad category that increased substantially was spending on intellectual capital, which in real terms expanded at a 7.8 percent rate, and even that was a slowdown from the almost 10 percent rate averaged during the two prior quarters.

These reports, do, however, overstate the problem. Capital spending in recent months like much of the rest of the economy, suffered unduly from three more or less transitory influences. A protracted dock strike on the west coast effectively blocked a major avenue for exports of capital equipment, especially computers, not a small part of the whole. Inordinately cold and stormy weather during the first three months of the year had a depressing effect on equipment sales as well. It had a still more depressing effect on construction, explaining the remarkable decline recorded in that area during the quarter. The precipitous drop in oil prices during the second half of 2014 prompted industry to slow exploration activity abruptly during the latter months of that year and the opening months of this one, leading to the tremendous drop in spending on all sorts of drilling and pipeline equipment.

But the strike has ended, as has the cold and stormy weather, inviting at least a partial reversal of their depressing effects in coming months. On this basis, the current quarter could easily witness a surge in sales of capital goods as well as a major uptick in commercial and industrial construction. There is also reason to look for relative stability in new spending on drilling equipment. To be sure, oil prices have only risen slightly, hardly enough to renew the pattern of widespread drilling and exploration that dominated much of 2013 and the first half of 2014. But there is ample reason to believe that the cutbacks of past months have already adjusted levels of activity to lower prices so that the industry no longer has need for further sharp cutbacks, certainly not of the sort suffered during the first quarter. Some of the drilling that was cancelled might even return. On these bases, the second and possibly third quarter could see a surge in spending on both equipment and construction that, except in the energy space, more or less recovers the ground lost in the first quarter.

Still, The Underlying Trends Don’t Look Good

Beneath these down-up gyrations, the fundamentals look weak, if not in outright decline. Orders for non-defense capital goods, including or excluding the volatile aircraft sector, show decreases over the last twelve months. The former fell 2.6 percent, while the latter fell 1.8 percent. These data are only available in nominal terms. When combined with the Commerce Departments, 1.1 percent inflation estimate for the sector, a real measure of these orders would respectively approach declines of 3.7 percent for overall non-defense capital goods orders and 2.9 percent when aircraft is excluded. To be sure, sales have held up during the past year, despite the orders decline. In real terms, sales of non-defense capital goods have risen an estimated 3.6 percent during the past 12 months, 1.6 percent after removing aircraft from the equation. But the sales are done, while the orders reflect on the future. It is doubtful that sales will follow orders down point for point, but the outlook is clearly soft.

It is also less than encouraging that capital spending was slowing even before the special depressing effects of the year’s first quarter. The rate of expansion in real overall spending by business on equipment, premises, and intellectual capital actually peaked as long ago as the fourth quarter of 2013 at an annual growth pace of 10.4 percent. It slowed to an average 7.1 percent annual growth rate during the first three quarters of 2014 and then slowed further to a 4.7 percent annual rate of gain in the fourth quarter, well before the first quarter distortions. The subsectors of structures and equipment spending followed the same slowing pattern, with growth in equipment spending all but stopping during last year’s fourth quarter, growing at only a 0.6 percent annual rate, before slowing even further to a negligible 0.1 percent rate of advance under the first quarter’s transitory constraints.

The only exception, and one bright spot, are patterns of spending on intellectual products, most notably research and development. Overall, such spending gained momentum throughout 2014, rising from a relatively slow 3.6 percent real annual growth rate at the end of 2013 to a 10.3 percent real annual rate of advance by the end of 2014. Even under the special retardants of the quarter just passed, this kind of spending continued to grow at the real 7.8 percent annual pace quoted earlier. This pattern was even more exaggerated in the R&D subcategory. It rose from a 3.6 percent real annual growth pace at the close of 2013 to a 17.2 percent rate at the end of 2014, sustaining a 12.3 percent annual rate of expansion even during the first quarter’s constrained environment.

Broader Implications

This middling underlying picture, apart from R&D, is not so weak, however, that it threatens an outright decline. It, as a consequence, is not likely to derail the recovery. Instead, it makes one more argument to expect the historically slow pace of overall economic growth to continue going forward. This prospect may not offer much inspiration, but it is hardly shocking, or should not be. It is, after all, the sort of recovery to which everyone has grown familiar during the past five-plus years. In time, as political matters clarify and the adverse legacy of the great recession wares off, the pace of growth, including in capital spending, may well pick up, but the data to date suggests that such a time is still relatively distant.

There is a still longer-term concern that requires attention. Weak business spending on equipment and premises says little good about future rates of productivity growth. Fewer relationships are better linked than the positive influence of capital spending on productivity. Not only does such spending give workers more support and so tends to enhance labor productivity, but by bringing new techniques and technologies into production processes – or, as economists say, embodied in the new equipment and facilities – the capital spending produces an acceleration in what economists call total factor productivity, the output from labor, land, and capital combined. The most recent evidence comes from the tremendous surge in capital spending that took place in the 1990s, largely in response to the technological revolution. After a time lag, during which business integrated the new technologies into its practices and processes, productivity surged in the early years of this century. Labor output per hour, for example, jumped from 1.7-1.8 percent annual rates of increase in the mid-to-late 1990s to over 3.0 percent annual rates of increase on average between 2000 and 2005.

Today’s substandard rates of capital spending suggest, then, slow productivity growth going forward, perhaps no better than the 1.5 percent annual growth rate for labor productivity averaged during the past five years. Even the one bright spot in today’s picture, rapid growth in R&D spending, can only offer so much encouragement. Unless the results of all the research and development inspires other sorts of capital spending, it will take a long while to filter into business practice and procedure and, accordingly, into an improved productivity picture. The hope then is that the R&D inspires spending on the new equipment and premises that can bring it into business and manufacturing practice. If recent figures are any indication, that prospect will remain a hope not an expectation for a while to come.